A company’s access to debt has traditionally not been among the most critical features that investors pay attention to. Even those investors and researchers who were concerned about how a company’s debt is structured often took a highly quantitative approach to this investigation. Other than in cases of clearly distressed companies, the question was rarely or ever asked: “If this company loses a debt facility, will another one be available?”

Given present economic uncertainty, more than one CFO has doubtless worried deeply over this issue. The question is, are investors incorporating the qualitative features of debt into their investment decisions?

Before this period of volatility, Canadian businesses that sought operating capital, or capital for growth, had two primary options: they could look to a U.S. financial institution or to a Canadian one. But U.S. banks are now retreating from the Canadian market, not necessarily due to fundamental issues with Canadian borrowers. Instead, they are conserving capital to support their core domestic operations. Similarly, our Canadian banks are committed to supporting their own core market and customers. To that end, they have provided much needed stability to their customers in recent times. However, in spite of Canadian financial institutions being among the strongest in the world, they too are constrained by the current market volatility. As a result, it’s fundamentally important for borrowing companies to actively manage relationships with their bankers, foreign or domestic.

Many banks that provide credit to help companies with their day-to-day operating needs, particularly loans that are backed by assets, are now reducing the availability of these types of loans. Typically, these financial institutions are raising their reserves and tightening their lending terms, based on a real or perceived deterioration in the quality of the assets securing the credit.

In short, there are fewer lenders and those that remain have fewer dollars available. In extreme cases, due to their capital provider’s lack of solvency, good companies may be seeing an immediate reduction in access to operating debt and long-term financing.

As a result, when assessing a company as an investment opportunity, traditional equity valuation metrics, such as P/E ratios, PEG and dividend yields, should take a back seat to methods that directly account for leverage, such as EV/forecast EBITDA. This analysis should be augmented by a more qualitative assessment of debt and capital-structure stability. In this new era of tight credit markets and unpredictable economic conditions, debt analysis should become much more comprehensive, and should include assessments of whether companies will be able to borrow in the future, what sort of terms lenders are likely to require, how will assets be valued and the terms (committed versus demand) of each debt facility.

The analysis should extend past the company to an assessment of the quality and nature of the financial institutions that may be providing credit. Key considerations of the lenders include: capital adequacy, transparency of the financial institution’s solvency and access to capital, prior market activities with similar customers and public messages, including plans to downsize operations.

Next, investors should examine the nature of the company’s relationship with its creditors. Is the company an important client of the financial institution? Does the relationship extend beyond access to credit into areas that produce non-interest income for the lender? What is the tenure of the relationship? In many situations, corporate borrowers will anticipate that the cost of borrowing and the terms of a loan will move against them when committed debt facilities reach their term. In the most challenging cases, committed facilities (364-day operating credit and term loans) will not be renewed on a committed basis. Rather, these loans will be converted to demand facilities, or worse, the credit will not be re-extended. The debt may be re-priced, terms tightened and effective amortizations reduced, leading to higher payments and a further constraint on cash flows in already volatile times. Companies that are mitigating these circumstances will be at a distinct advantage over their competitors.

Even within organizations with relatively low debt levels, continuing access to working capital and funding for maintenance and expansion of their operations will set them apart from their competitors. In essence, banks are now playing the role of company “sponsors,” in the same way that other entities, such as corporate parents and private equity funds, have done in the past in situations such as management buyouts or leveraged buyouts. As a result, the lines between debt and equity are becoming rather grey.

@page_break@Only months ago, borrowers would often set lenders in competition against one another to obtain a small change in terms, such as a rate reduction of a few basis points. In a sense, debt had become a commodity — an undifferentiated product in a highly competitive environment. Today, it’s unlikely any company is entertaining so many favourable offers from lenders that they can “tune up” rates to shave off 10 bps. Rather, the stability of credit relationships and the related facilities — regardless of micro considerations — is of critical strategic importance to companies, as they work to create shareholder value in these turbulent times. IE



Matt Hurlburt, CFA, CF is in corporate finance with Deloitte Canada.